Currency Swaps

Introduction:
Currency swaps involve an exchange of cash flows in two different currencies. It is generally used to raise funds in a market where the corporate has a comparative advantage and to achieve a portfolio in a different currency of his choice, at a cost lower than if he accessed the market of the second currency directly. However, since these types of swaps involve an exchange of two currencies, an exchange rate, generally the prevailing spot rate is used to calculate the amount of cash flows, apart from interest rates relevant to these two currencies. By its special nature, these instruments are used for hedging risk arising out of interest rates and exchange rates.

A currency swap is a foreign-exchange agreement between two parties to exchangeaspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see Foreign exchange derivative. Currency swaps are motivated by comparative advantage. A swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on the balance sheet. In other words: A currency swap is an agreement between two parties to exchange the principal loan amount and interest applicable on it in one currency with the principal and interest payments on an equal loan in another currency. These contracts are valid for a specific period, which could range up to ten years, and are typically used to exchange fixed-rate interest payments for floating-rate payments on dates specified by the two parties.Since the exchange of payment takes place in two different currencies, the prevailing spot rate is used to calculate the payment amount. This financial instrument is used to hedge interest rate risks.

Definition:
A currency swap is a contract which commits two counter parties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.

Structure:
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.

There are three different ways in which currency swaps can exchange loans: The most simple currency swap structure is to exchange the principal only with the counterparty, at a rate agreed now, at some specified point in the future. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap. Another currency swap structure is to combine the exchange of loan principal, as above,with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a Vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan. Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US Dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or crosscurrency swap.

Consider a swap in which:

Bank UK commits to pay Bank US, over a period of 2 years, a stream of interest on USD 14 million, the interest rate is agreed when the swap is negotiated; in exchange, Bank US commits to pay Bank UK, over the same period, a counter stream of sterling interest on GBP 10 million; this interest rate is also agreed when the swap is negotiated. Bank UK and Bank US also commit to exchange, at the end of the two year period, the principals of USD 14 million and GBP 10 million on which interest payments are being made; the exchange rate of 1.4000 is agreed at the start of the swap. We can now see from the above that currency swaps differ from interest rate swaps in that currency swaps involve: An exchange of payments in two currencies. Not only exchange of interest, but also an exchange of principal amounts. Unlike interest rate swaps, currency swaps are not off balance sheet instruments since they involve exchange of principal at the end of the period. The idea of entering into the currency swap is that, Bank US is probably expecting an amount of GBP 10 million at the end of the period, while Bank UK is expecting an amount of USD 14 million, which they agreed to exchange at the end of the period at a mutually agreed exchange rate. The interest payments at various intervals are calculated either at a fixed interest rate or a floating rate index as agreed between the parties. Currency swaps can also use two fixed interest rates for the two different currencies different from the interest rate swaps. The agreed exchange rate need not be related to the market. The principal amounts can be exchanged even at the start of the swap

Diagram:

If in the above-mentioned swap, the two banks agree to exchange the principal at the beginning. Bank UK will sell GBP to Bank US in exchange for US Dollars. This would be at an exchange rate, most likely the spot rate. These banks would borrow the respective currencies, which they have sold. But at maturity, this exchange of principal would be reversed at the original exchange rate. (This kind of swap is called a par swap).

Types of Currency Swaps:

Cross-currency coupon swaps: These are fixed-against-floating swaps. Cross-currency basis swap: These swaps involve payments attached to a floating rate index for both the currencies. In other words, floating-against-floating cross-currency basis swaps. Diagram: Risk Management with currency swaps: Example: (Principal exchanged at Maturity) A UK Co. With mainly sterling revenues, has borrowed fixed-interest dollars in order to purchase machinery from the U.S. It now expects the GBP to depreciate against the USD and is worried about increase in its cost of repayment. It could now hedge its exposure to a dollar appreciation by using a GBP/USD currency swap. It would fix the rate at which the company, at maturity, could exchange its accumulated sterling revenues for the dollars needed to repay the borrowing. Fixing the exchange rate hedges the currency risk in borrowing dollars and repaying through sterling. Assuming, the Company expects not only the dollar to appreciate, but also the GBP interest rates to fall. It could take advantage of this situation, by Currency Swaps swapping from fixed-interest dollars into floating interest sterling. Diagram: Stages: At the start of the swap, the GBP/USD rate is agreed at which the principal amounts will be exchanged at maturity (probably, the prevailing GBP/USD spot rate) At the same time, interest rates for use in the swap are also agreed Over the life of the swap, the UK Company will pay a stream of sterling floating interest through the swap and will receive a counter stream of dollar fixed interest in exchange. The dollar interest received through the swap will be used to service the dollar borrowing; the sterling interest paid through the swap will be funded from earnings. At maturity, the company will pay a sterling principal amount through the swap and receive a dollar principal amount in exchange. The exchange is made at the GBP/USD rate agreed at the start of the

swap. The company will fund its payment of principal through the swap from accumulated sterling earnings from its business and will use the dollar principal it receives in exchange to repay its dollar borrowing. Example: (Principal exchanged at the beginning) This will be the case when the UK co. wants to swap its dollar loan into a sterling loan, but needs dollars at the outset to pay for dollar imports or for any other purpose. In this case, the UK co. would simply acquire the dollars from the spot foreign exchange market. It would fund this spot purchase of dollars with the sterling received through the swap in the initial exchange of principal amounts. Diagram: Stages: At the start of the swap, the UK co. buys dollars against sterling in the spot market. The dollar bought in the spot are exchanged through the swap for sterling, at the same GBP/USD exchange rate at which the UK co. had to buy dollars against sterling in the spot market; the sterling received through the swap is used to fund the spot purchase of the dollars. At the same time, the GBP/USD rate at which the principal amounts will be exchanged at maturity is fixed at the spot rate at which the UK co. had to buy dollar against sterling in the spot. The interest rates for use in the swap are also agreed; Over the life of the swap, the UK co. will pay a stream of sterling interest through the swap and will receive a counter stream of dollar interest in exchange. The dollar interest received will be used to service to the dollar borrowing; the sterling interest paid through the swap will be funded from earnings. At maturity, the co. will pay a sterling principal amount through the swap and receive a dollar principal amount in exchange. The exchange is made at the GBP/USD rate agreed at the start of the swap. The co. will fund its payment of principal through the swap from accumulated sterling earnings from its operations and will use the dollar principal, it receives in exchange, to repay its dollar borrowing.

Swap Market in India.

In India, the Reserve Bank of India has permitted banks to arrange currency swaps with one currency leg being Indian Rupee. However, the USD/INR forward foreign exchange markets are illiquid beyond one year. Since currency swaps involve the forward foreign exchange markets also, there are limitations to entering the Indian Rupee currency swaps beyond twelve months. Moreover, banks are also not allowed to take risk /run open swap books i.e., they have to locate counter parties with matching requirements; e.g. one desiring to swap a dollar liabilities into rupee liabilities and the other wishing to exchange rupee debt servicing obligation for dollar obligations. However, some aggressive banks do provide quotes for currency swaps for three to five years out for reasonable size transactions. Corporates who have huge rupee liabilities and want have foreign currency loans in their books, both as a diversification as well as a cost reduction exercise could achieve their objective by swapping their rupee loans into foreign currency loans through the dollar/rupee swap route. However, the company is assuming currency risk in the process and unless carefully managed, might end up increasing the cost of the loan instead of reducing it.

In India, it is more the norm for corporates to swap their foreign currency loans into rupee liabilities rather than the other way round. Example: A corporate has a loan of USD 10 million outstanding with remaining maturity of 2 years, interest on which is payable every six months linked to 6-month Libor + 150 basis points. This dollar loan can be effectively converted into a fixed rate rupee loan through a currency swap. If the corporate wants to enter into a currency swap to convert his loan interest payments and principal into INR, he can find a banker with whom he can exchange the USD interest payments for INR interest payments and a notional amount of principal at the end of the swap period. The banker quotes a rate of say 10.75% for a USD/INR swap. The total cost for the corporate would now work out to 12.25%. If the spot rate on the date of transaction is 44.65, the rupee liability gets fixed at Rs. 446.50 mio. At the end of the swap, the bank delivers USD 10 million to the corporate for anexchange of INR 446.50 mio, which is used by the corporate to repay his USD loan. The corporate is able to switch from foreign currency.

Uses
Currency swaps have two main uses: To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-backloan). To hedge against (reduce exposure to) exchange rate fluctuations

Hedging Example
For instance, a US-based company needing to borrow Swiss Francs, and a Swissbasedcompany needing to borrow a similar present value in US Dollars, could both reduce their exposure to exchange rate fluctuations by arranging any one of the following: If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency. Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap.

History
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies wishing to borrow Sterling. While such restrictions on currency exchange have since become rare, savings are still available from back-to-back loans due to comparative advantage. Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with a notional amount of $210 million dollars and a term of over ten years. During the global financial crisis of 2008, the currency

swap transaction structure was used by the United States Federal Reserve System to establish central bank liquidity swaps. In these, the Federal Reserve and the central bank of a developed or stable emerging economy agree to exchange domestic currencies at the current prevailing market exchange rate & agree to reverse the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps is "to provide liquidity in U.S. dollars to overseas markets." While central bank liquidity swaps and currency swaps are structurally the same, currency swaps are commercial transactions driven by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars to overseas markets, and it is currently unknown whether or not they will be beneficial for the Dollar or the US in the long-term. The People's Republic of China has multiple year currency swap agreements of the Renminbi with Argentina, Belarus, Hong Kong, Indonesia, Malaysia, and South Korea that perform a similar function to central bank liquidity swaps.

How Does a Currency Swap Work?

A currency swap agreement specifies the principal amount to be swapped, a common maturity period and the interest and exchange rates determined at the commencement of the contract. The two parties would continue to exchange the interest payment at the predetermined rate until the maturity period is reached. On the date of maturity, the two parties swap the principal amount specified in the contract. The equivalent amount of the loan value in another currency is calculated by using the net present value (NPV). This implies that the exchange of the principal amount is carried out at market rates during the inception and maturity periods of the agreement.

Benefits of Currency Swaps

The benefits of currency swaps are:
Help portfolio managers regulate their exposure to interest rates. Speculators can benefit from a favorable change in interest rates. Reduce uncertainty associated with future cash flows as it enables companies to modify their debt conditions. Reduce costs and risks associated with currency exchange. Companies having fixed rate liabilities can capitalize on floating-rate swaps and vise versa,based on the prevailing economic scenario.

Limitations of Currency Swaps

The drawbacks of currency swaps are:
Exposed to credit risk as either one or both the parties could default on interest and principal payments. Vulnerable to the central governments intervention in the exchange markets. This happens when the government of a country acquires huge foreign debts to temporarily support a declining currency. This leads to a huge downturn in the value of the domestic currency.

Who would use a swap?

The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (i.e., liabilities) and earns a fixed rate of interest on loans (i.e., assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floatingrate assets, which would match up well with its floatingrate liabilities. Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing. For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less well known. It will likely receive more favorable financing terms in the US. By then using a currency swap, the firm ends with the euros it needs to fund its expansion.

Exiting a Swap Agreement

Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this. 1. Buy Out the Counterparty Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent. 2. Enter an Offsetting Swap For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.

3. Sell the Swap to Someone Else

Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty. 4. Use a Swaption A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy